Inflation is just right for the US Federal Reserve – not too hot, nor too cold. For now...
U.S. MONETARY POLICY makers have enjoyed a Goldilocks environment since they began the most intense phase of inflationary monetary policy, writes Gary Tanashian in his Notes from the Rabbit Hole.
We'll define that period as post-Operation Twist, beginning in January of 2013. Goldilocks held sway because of a lag in inflation's rising cost effects in the transition from economic contraction to economic expansion.
But the expansion (such as it is) was willed into existence by a Fed sopping up commercial and government bonds (legacy debt) with newly printed money. The story goes that this newly printed money will somehow enter the economy and become accretive to productive economic activity. But it will not.
The newly created money is entering the financial sphere and seeking assets with which to try to transform itself from printed funny munny to actual value. Actual value could be found in the US stock market in 2012. But typical of funny munny, it may not know when to stop and move on to something else deserving of the 'value' bid. That is because it is funnymunny and it is all about momentum. It is 'hot' money.
Housing, crude oil, uranium, copper, the Chinese stock market, rare earth elements, silver and even gold have all received the 'funny munny on the run' bid at various times and to varying degrees in the last decade; so why not US stocks? Why not for once a Federal Reserve chief able to stand up and accept the accolades as the great "Hero"?
But economies and financial markets do not work that way. Only productive economic endeavor can create long-term economic growth. By relying on its ability to buy massive amounts of debt in a systematic and open-ended manner, the US Federal Reserve is distorting the signals traditionally put out by important debt (bond) markets.
This is about the point where I would normally insert the Outer Limits graphic and the funny stuff like "...sit quietly and we will control all that you see and here." But instead, this time we'll play serious newsletter writer and just get to the facts and ask what happens if the bond markets throw off predatory policy makers like so many fleas?
Think about all the moving parts to the global picture. China is having economic and political issues. Japan has committed to the path of intense inflation. What will that do to its own JGB (bond) market? Now consider that these are two holders of massive amounts of US Treasury bonds, the very instruments that "our hero" (the Atlantic's words, not mine) at the Fed is using to engineer recovery in the United States.
Printing new money to buy old debt is inflationary. We see that now in the rising Monetary Base data. If China and Japan begin burping up US T bonds in large volumes in order to raise capital to attend to their own internal affairs even more intense operations in the Treasury bond market may be required of our "hero".
Or will the inflation regime just end with a nice and tidy exit plan as the US economy gets the wind in its sails with organic growth and a clear path to prosperity? With the massive amounts of T bonds held in potentially unstable hands globally and with the pressure to continue buying these bonds domestically (QE) it sure does look like 'inflate or die'. Would the 'organic' economy survive impulsively rising interest rates?
A symbolic economic death would come by one of two ends. It could resolve into an inflationary spiral, where scores of asset mongering frogs will be boiled slowly as they at first come to feel enriched, but then come to feel threatened by a spiral of prices rising so fast that the inflation-fueled casino atmosphere begins to feel very out of control and threatening to every day life.
Or more realistically (in my opinion) the inflationary game will go on until something breaks once again; some leveraged thing at the heart of the interconnected global casino just goes dark one day and begins another domino effect throughout the financial system. This is of course a deflationary resolution and in my opinion, solution. Much destruction, with the idea that maybe our children and grandchildren will be the better for it after a phase of intense adjustment (read: pain).
A hard drug user experiences pain on the path to recovery. Developed economies are still in the 'user' category and it appears that recovery is going to have to be imposed, because the addicts are not voluntarily submitting to rehab.
Instead they are pursuing more intense forms of the destructive behavior that put the system in such a precarious state to begin with. This is not my opinion; it is fact. The fact is that new money is being printed to pay for old debt that would not be effectively serviced on its own, and the proceeds are being employed toward market sustaining liquidity under the guise of stimulating economic growth. Well yes, some of that is my opinion. But the fact is that there are positive economic signs popping up – which we had anticipated – and yet still they inflate.
On Wednesday the FOMC will conclude a 2-day meeting, followed by a press conference with Bernanke. If they make stronger sounds about a QE exit plan (the markets and to a lesser degree the economy are heating up after all) then we will see if all of the above is just the doomsday fantasy of a loony letter writer or just maybe a well thought out path to difficult times ahead. The implication is that the 'organic' economy would be left to fend for itself after all.
They may again note the muted inflation signals in the things most people look at, which are prices. But the February CPI data was a step in a mitigating direction for our heroic inflators. This is a notable lagging effect of current inflationary policy to date.
If stock markets continue to rise and if economic activity continues to grind in a positive direction we will be approaching a policy pivot point. That would be the point where Joe Public begins to question 'why on earth are they still printing money in the face of Dow 15,000, improving 'jobs' and my own bright and sunny outlook?'
The answer, dear public, is the same as it was in 2004, when I wrote my first public article, FrankenMarket Lives:
"So where does this leave our poor monster, sloppily stitched together and meandering aimlessly forward? The market will look to the economy, and being a forward looking monster, I expect it to see one of two things; The Fed taking away the punch bowl for real, deciding too late that the party is over, or more realistically, it will see a Fed doing all it can to sustain the monster it created. This market was stitched together with debt, and it will require more of the same to keep it going. We are knocking on the door of hyperinflation, and I believe the Fed will choose to open that door, given that it is too late for our economy to de-leverage in any orderly fashion."
Opening the door to hyperinflation by the way, does not mean a hyperinflationary resolution. I prefer the view of a deflationary unwinding (deleveraging), despite intense inflationary efforts.
Now that we have gone over one writer's not very happy view of things, let's proceed to the next part of the analysis – how to play it.
Things are about to get cooking in the financial markets as an over bought US market sponsored by greedy, momentum-based money hits upside targets and cycle time lines, and gold – 1.5 years in the desert – comes to an opposite condition. Policy makers are in play with Cyprus roiling the markets currently, the US FOMC on tap and an entire global casino readying for what should be a very dynamic 2013.
Alice, the young lady who is the inspiration for my newsletter, was a contrarian. I think Alice would do well if she were participating in our modern day financial markets in 2013. It is going to be a good year to be contrary the popular themes of the moment.